In a note to clients this afternoon, Eric Green, global head of rates, FX, and commodities research at TD Securities, warns that “stocks look more vulnerable than ever,” as prices have outrun improvements in fundamentals.
A prevailing view among many has been that the portfolio substitution effect of QE inflated risk assets such as equities beyond reason. When the Fed began talking about tapering, however, there was no evidence that stocks were overvalued. Narrow profits as a percentage of gross value added were very much consistent with stocks priced in the 1550 range. However, since that time the S&P 500 has risen almost 11% after trading sideways between May and early September. Indeed the leg up from 1650 after the no tapering decision in September has not been supported by underlying growth and earnings fundamentals. Part of this may be attributed to a ‘low for longer’ theme that has gained more traction relative to the lead up to the September meeting.
Part of this may also be due to a tapering event that many may view as a vote of confidence in the recovery. Either way, however, equities look toppish at this point. As tapering expectations coalesce the bias is clearly lower, particularly in the US where cyclically adjusted PE ratios for non-financial corporates have run well ahead of their counterparts in the UK or Europe.
A 5% to 10% correction in stock prices is now a reasonable expectation, but it is a correction that provides better entry points and is a correction that will prove short-lived as economic maths in 2014 is tilted to 2.5%, or higher. Nevertheless, what weaker stock prices will do over the near term is dull some of the pain in Treasuries that are otherwise better positioned for tapering. Yields are set to drift higher, and 3.0% 10 year yields looks reasonable over the next month, but in a low inflation environment and a central bank seemingly on hold forever, a rout does not loom.
The bottom line, according to Green: “At current levels, Treasuries could well outperform other risky assets such as equities that appear more vulnerable than ever as the Fed tiptoes to tapering.”
Others on the Street have echoed such sentiments today as well.
“Risk markets are feeling wobbly, and that’s helping developed bond markets find their feet for now,” wrote Société Générale interest rate strategists Ciaran O’Hagan and Vincent Chaigneau in a note to clients this morning.
Treasuries sold off today in the wake of a better-than-expected ADP employment report, which showed a marked acceleration in private-sector job growth in November. Stocks closed down marginally.
The SocGen strategists say the threat better economic data pose Treasuries is “a limited one if tapering-centred risk assets do not react well to solid data.”
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